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October 6, 2013

Sweat the Debt, Not the Shutdown

Stock markets are shrugging off the political mess, but will the bond markets be so kind later this month?

Memo to the President and Congress: The stock market doesn’t care about your shutdown nonsense. But it does care about the debt limit.

Stocks shrugged off the first full day of the historic 2013 government closure. The Dow Industrials added 0.41%, the S&P 500 gained 0.80%, and the Nasdaq composite jumped 1.23%. The stock market virtually aped its historical performance during the last two government closures in 1995 and 1996.

But one day’s performance doesn’t necessarily make a trend, nor does it mean financial markets will forgivingly tolerate everything the government does.

During 2011, the debt ceiling brouhaha, something happened that we shouldn’t soon forget. As politicians on both sides of the aisle were bickering, the S&P 500 (SPY) swiftly declined 16.58% from July 22 to Aug. 8.

That provided a clear message: Financial markets don’t like political grandstanding, particularly when it impacts something as meaningful as sovereign debt.

This time around, the U.S. Treasury’s borrowing limit is exhausted on Oct. 17, and the Congressional Budget Office estimates the government won’t have enough money to pay its bills sometime between Oct. 22 and Oct. 31.

Debt Dilemma

Will Democrats and Republicans be able to agree on a believable plan for tackling national debt?

Basically, Congress is stuck with two choices: increasing the debt limit or defaulting on it, with the former being the best of the worst possible choices.

Congress has raised or suspended previous limits five times under the Obama administration. Raising the debt limit or suspending it has been the modus operandi of Congress on 79 separate occasions since 1960. (After 53 years of practice, they’ve sure developed a real knack for it.)

On the other hand, a debt default is the worst of worst choices. Not only would it roil the appetite for U.S. debt, but it would trigger another credit downgrade for the nation.

It would likely cause the U.S. government’s borrowing costs to sharply rise, and for the broader U.S. economy, that would mean even higher interest rates on top of the 60% year-over-year increase it’s already experienced in the yield on 10-year Treasuries.

In other words, besides political suicide, it would be economic suicide.

Regardless of what happens later this month, there’s much more to consider – as the Congressional Research Service sums up: “Over the next decade, without major changes in federal policies, persistent and possibly growing deficits, along with the ongoing growth in the debt holdings of government accounts, would increase substantially the amount of federal debt. Unless federal policies change, Congress would repeatedly face demands to raise the debt limit to accommodate the growing federal debt in order to provide the government with the means to meet its financial obligations.”

Outstanding total public debt is now $38.76 billion above the legal debt limit, and currently stands at $16.699 trillion.

(The Treasury Department has conveniently itemized this same $38.76 billion as "not subject to the debt limit;" this technique is known as "creative accounting" and anybody who tried to use it in Corporate America would go straight to jail.)

If the U.S. Treasury has already subversively exceeded its legally mandated borrowing limit, as its own financial statement suggests, then the upcoming debt debate is nothing more than an epic dog and pony show.

The next question is this: Will you be a sucker or a profiteer from the bond market’s next big move?

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